International Economy 11 International Economy Week 6 Prepared by Shi Young Lee* (Chung-Ang University)

Contents 1. Infant Industry Protection Argument and Strategy 2. Political Economy Approach - FTA - What’s so Special about Agriculture? 3. Perception Game & Policy: Application to Korea-US FTA

Infant Industry Protection Once Again  Infant Industry Protection Argument - Infant industry protection: protection is given to a specific start-up industry so that it can be competitive in the international market (in the future) - Financing, interest ceiling, prohibitive tariff, subsidy are often used to protect the infant industries - In the background, the infant industry protection implies implicit government guarantee (otherwise, it is unlikely for business entrepreneurs to undertake risky investment in the first place) - In theory, the protection can make the infant industry competitive in the international market

Infant Industry Protection & Strategy  Infant Industry Protection and Moral Hazard - With implicit government guarantee, business entrepreneurs undertake risky investment schemes and induce moral hazard problem - The result: business entrepreneurs of infant industries are interested in expanding the size (especially in terms of employment)  Once its size becomes sufficiently large, it is difficult for the government to kill such industries  politically infeasible - After few years, the government and infant industry often can form a coalition  this coalition will strengthen and build up establishment which is unlikely to break up

Infant Industry Protection & Strategy  Strategy under Infant Industry Protection - Infant industry protection only applies to LDCs - Due to the rents from protection, firms may compete to win the prize  rent-seeking activities related to win the protection from the government - Bribery and favoritism are often used as a means to win the protection - Examples from China and Korea: Guanxi is often used to win the protection and favoritism  In this case, it is difficult to crack down guanxi related corruption (Why?)

Political Economy Approach  Introduction to Political Economy Approach - Political economy approach dictates that every policy generates winners and losers - The equilibrium policy may be the outcome of political process  Most likely, political process involves interactions among winners and losers (and uninterested party) - The policy outcome (equilibrium policy) is nothing to do with the efficiency of policy  Often an inefficient policy turns out to be the equilibrium policy outcome - Example: tariff, quota, and antidumping policy and protection of declining industries

Political Economy Approach  Rule of the Policy Game - Every policy generates winners and losers - Identification of winners and losers first and then estimate the size of loss and gains - After the size of gain and loss is estimated  If the size of gain is larger than loss, then it is an efficient policy - If the size of gain is smaller than loss, then it may be an inefficient policy - Rule of the game: pursue if efficient do not pursue if inefficient

Political Economy Approach  Why Inefficient Policy Outcome May Arise - If the size of gain is larger than loss, in theory, the government can compensate the loss for the losers with the gains from the winners - However, in reality, even though the size of gain is unambiguously perceived larger than the loss, this policy may not be pursued ! (1) The size of gain and loss may not be agreed between losers and winners: Estimation problem (i) Losers tend to claim the size of loss is large (ii) Winners tend to claim that the size of gain is small (iii) Mismatch leads to no trade outcome  efficient policies may not be pursued

Political Economy Approach  Why Inefficient Policy Outcome May Arise (2) Credibility problem - In the compensation game, the role of government is crucial  The government has to credibly promise the compensation scheme to losers a priori - If the losers do not trust the promise made by the government, then no trade outcome may be the equilibrium outcome  the go-between function of the government is crucial in delivering an efficient policy - Otherwise, the government can face strong resistance due to lack of credibility Summary: In reality, the credibility and estimation problem create a serious obstacle to pursue an efficient policy and this is why inefficient policies turn out to be the equilibrium policy outcomes frequently

Political Economy Approach & FTA  Chile-Korea FTA - FTA implies 0 tariff between the two (agreed) countries  FTA generates trade creation and trade diversion effects - In case of Chile-Korea FTA, losers and winners can be easily identified ex-ante - From the start, the agricultural sector (perceived to be a loser) strongly resists to this policy and claims that the agricultural sector is going to be wiped out! - A possible reason why the agricultural sector sends a fear-inducing & anxiety-creating message is to unite the agricultural sector as a whole - It was successful in bringing in unity and the agricultural sector strongly resists to the policy and was able to win a generous compensation scheme - Since the size of compensation is positively related to the resistance level, it is likely for potential losers to strongly resist to the policy - Agricultural sector is granted with seasonal tariff on grape and exemptions applied to apples and pears+ generous compensation scheme

Chile-Korea FTA: Competitiveness and Protection by Industries

Political Economy Approach & FTA  Japan-Korea FTA - From the start for some unknown reasons, political economy side is largely neglected from the start  heading to fiasco - The size of economic gains is not large because Japan was reluctant to open up its agricultural and fishery sectors - Some manufacturing industries (including automobile industry) perceive themselves as losers and as a result were afraid of opening up their markets to Japan - Another concern for Korea was the key intermediary input industries

Global Business & Trade 13 Industry Analysis of FTA between Japan and Korea Injury Industries for Korea: RCA 1 Injury Industries for Japan: RCA>1, RCA*<1 Power Generating Equipments Machinery Electrical Equipment Motor Vehicle Parts Etc. Plastic Products Leather Textile/Fabric Cloth Copper/ Zinc Etc. Determination of Injury Industries Due to FTA between Japan and Korea, key intermediary input industries would suffer in Korea while textile and plastic industries would suffer in Japan.

Global Business & Trade 14 Political Economy Approach & FTA - Economic gains vs. Political Cost (i) This example demonstrates that the economic gains and political cost may be inter-related (ii) In the case of Japan-Korea FTA, political costs may stem from national sentiment and potentially injured industries  They can take advantage of national sentiment when they oppose to this policy (iii) Negative national sentiment toward a potential FTA partner shrinks the win-set  unable to generate sufficient win-set to ratify Japan-Korea FTA policy

Political Economy Approach & FTA - Summary: (i) Intrinsic political costs were not carefully considered by policy makers  National sentiment toward Japan (possibly from historical background) always could induce bargaining impasse regardless of the size of economic gain (ii) Potential losers take advantage of this condition and stress the negative sentiment toward Japan when they tactically resist to this policy  effective resistance tactic

Political Economy Approach & FTA (iii) Political interests push Japan-Korea FTA  However, since policy entrepreneurs did not consider political cost, this policy leads to bargaining impasse (iv) The government wasted precious two and half years and turn to Korea-US FTA

What’s so Special about Agricultural Sector ?  Positive Question: Why do we protect agricultural sector? - Many countries (LDCs as well as DCs) at least try to protect their agricultural industries - A political economy approach is adopted to explain this question - Two types of political costs can be realized if we decide not to protect the agricultural sector (i) Institutional cost (ii) Sentiment constraint

What’s so Special about Agricultural Sector ?  Institutional Cost - Agents employed in agricultural sector happen to be old (aged) and less educated - Aged and low education level imply low human capital endowed in the agricultural sector - Without protection, the agricultural sector may have to contract  in this case, may have to incur huge adjustment cost because of low human capital level associated - In order to avoid (or minimize) political cost, political process protects the agricultural sector - Another institutional cost involves with the agricultural sector is over– representation

What’s so Special about Agricultural Sector ?  Sentiment Constraint - Some politicians who represent urban area favor the protection of agricultural sector - Voters from urban areas (some happen to be poor) also favor the protection of agricultural sector - Possible rationales: (i) Sentiment attached to the agricultural sector  because their origins stem from farm and many relatives live there and connected to them still (ii) Self-sufficiency of food is politically correct